07-15-2020

None of the following is investment advice. The following also is not a forecast by any means – it is what is happening all over the world right now. Josh Harris from Apollo recently was quoted on Bloomberg saying that there is 90% correlation to Fed printing and market performance. Enjoy.

More and more clients and colleagues are sounding the alarms on valuations, and rightly so. The best investors of all time, from Stephen Schwarzman to Warren Buffett tell others to sell when things are irrational and fundamentals aren’t showing up. Specifically, Schwarzman, in his book, “What it Takes” has 3 basic rules, which I’ll paraphrase.

1) Market tops are relatively easy to recognize. Buyers are overconfident and always believe “This time is different”

2) There’s always a surplus of cheap debt in a hot market. In some cases, lenders don’t charge cash interest and relax restrictions. Buyers accept overoptimistic accounting adjustmentds (i.e. adjusted EBITDA) to justify losses and debt.

3) There are a lot of people “accidentally” getting rich without any particular strategy.

So what do we make of where we are today? Frankly, this time truly is different… to a point.

I have been shocked with the amount of people just out of college throwing everything they have at the market with the reason of “The Fed’s printer will bail us out of any losses.”

Of course, this is absoultely true, and of course that consequence of overconfident retail investors is better than the consequence of a ruined equity market. Fact is, when confronted with the question, “Would you rather not bail out the economy and let much of society (including pension plans, banks and businesses) lose almost everything, or would you rather have an incredibly expensive stock market”, the answer must always be the latter. For a politician, any other decision would be career ending.

Many of these people sounding the alarm aren’t considering this premise, which will probably continue to frustrate them to the point that they eventually reenter in coming months. The consideration of investing when you don’t know the future earnings of the companies you are investing in at a time when nobody knows when we can live normally again, if ever, delivers us to the conclusion that there are more risks in nearly every market than there ever has been before, based on historical precedent.

From here, we could take this article many directions –

  • Psychology of not investing in a rising market
  • Psychology of investing at record highs
  • Catalysts/Trends that are predicting moves higher
  • Catalysts/Trends that are predicting moves lower
  • How will the giant deficit be paid for ultimately?

But we will instead work on these altogether –

  1. Why does printing money cause a safety net, really?
  2. What can stop the rally?
  3. Will the market ever correspond to fundamentals again?
  4. How can you earn a reasonable rate of return with low risk?

My opinion on these in summary –

  1. Money taken out of the market will be replaced by new coming in.
  2. More money leaving the market than coming in.
  3. Not for a very long time, probably. Nothing wrong with this.
  4. Very short term, inflation-proof bond portfolio

Let’s go further in depth on these points.

Think of a Bond. The value of a bond is mostly determined by three things – the ability of the borrower to pay back the loan amount, the length of time the borrower has to repay the loan, and the amount of interest it pays on that loan.

The ability to pay interest and repay the loan amount are determined by the cash flows of the business (generally), meaning that strong cash flows mean lower interest rates and a high probability of repaying the loan at some point before it’s due.

With the current crisis, many borrowers have lost cash flow, so in theory they can’t pay the interest and have a much lower chance of paying back loan amounts on borrowings, by no real fault of their own.

Enter the Fed, which has pledged to buy those loans from most of the best borrowers, and even many subprime borrowers. What this means is that the Fed is presenting these companies with a chance to use government money to both pay interest and repay the loan amounts. This will likely go on for years, if history is any guide.

So that same bond without help might cause the company to default and be worth $0, but with help is priced at $100. This is critical, as those bonds allow the company to focus any cash flows on increasing the value of equity, theoretically*.

*As an aside, the point of borrowing is nearly always to increase the value of equity. The equity in a company with the risk of default drops because borrowers pay back loans with company asset sales, and anything left over goes to equity holders. This is primarily why equity is riskier than debt.

With Fed interventions, the chance of default is virtually 0% for the majority of corporations, meaning that the present value of equity is safe, and probably MORE attractive than before. Thus, equity is more expensive, even though fundamentals haven’t changed.

So the probability of investors taking money out of either bonds or equities when both are virtually riskless is very low. In fact, even more investors will enter the market while there is money printing, since there is such little risk of default. This leads to the next point – the cause of a drop would be due to more money leaving the market than entering.

There are reasons for money to leave a market, but in the US the chance is lower than other places since nearly 75% of all global transactions are done in US dollars. Let’s not go down that rabbit hole – sufficed to say that the ‘reserve’ status allows the US to print virtually infinite amounts of money in theory. We will cover inflation in a bit. However, if the Fed decides to stop printing money, the market will fall precipitously and immediately.

Another reason for more money leaving the market than new money entering would be poor results and/or forecasts. If companies project bad futures, equities and bonds would probably drop in value as investors sell.

Today, we now have this very situation where bond and stock markets are incredibly expensive. Very thoughtful, intelligent investors can’t get themselves to invest, and for good reason. None of us are getting any information on the results/forecasts of the largest companies, and many consumers don’t have the demand to pay for goods and services as before the crisis. To invest in a company that doesn’t know if its own business is viable isn’t just risky, it’s unintelligent. Nonetheless, the Fed has your back.

Universal Basic Income (or at least stimulus checks) will heighten the probability of those companies seeing the same demand as before the crisis. If consumers can spend like before even in unemployment, businesses are safe and even MORE attractive.

Keep in mind that these are all grave scenarios, so if we get through everything and still have these stimulative policies, we are heading for an incredible boom in bond and equity markets. It is what it is – the correlations to fundamentals is a small price for markets to pay if it means the entire system won’t collapse.

Finally, how do you avoid these risks and earn a ‘decent’ return when inflation is* and will continue to be high?

*Inflation is high as stock and bond markets have jumped to such expensive levels. Cash, on the other hand, has had a negative return compared to say, technology stocks and investment grade bonds this year. This is the most interesting fallout of it all to me. Assets have become so expensive that anyone not invested now looks at the market just like someone in the Weimar Republic looked at a loaf of bread. Standards of Living roughly haven’t changed, but in order to invest, you now have to pay a lot more and that trend will probably continue.

So in my opinion, Inflation as classically defined doesn’t exist right now, though it could grow if people begin demanding normal goods more than supplying them. The likelihood of that is not as great as continued inflation of financial assets.

To get a decent return, you probably have to invest in equities (including real estate equities) and investment grade bonds. You can invest in riskier things, but if we see earnings projections fall below what we expect today for whatever reason, you will be burned more than you would by owning less risky investments.

You can invest in money markets and treasuries, but if your goal* is to wait for a drop in equities and bonds, you are taking a massive risk inherently. Not only that, but you will be pulling your hair out trying to find a good time to reenter the market.

This is why investing in a good financial advisor is very important. It is my opinion that waiting for a drop is both risky and pessimistic, two things that, in tandem, nearly always destroy potential gains. By investing in a competent advisor, you allow yourself to be removed from potential bias and related stress of such important decisions. Find someone that understands your financial goals, someone that you believe understands markets better than you do, and someone that has the ability to execute well. It could be the best investment you ever make!

*Now, if you can’t afford to take risks because you are on a fixed income and can’t afford to lose capital, you may need to stay in cash/treasuries.

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